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KAPLAN PUBLISHING 1 QUESTIONS

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KAP LA N P UBL IS HI NG 1

QUESTIONS

PAPE R F 9 : F I NA NCIA L MA NAG EM ENT

2 KAP LA N P UBL IS HI NG

MAXIMISATION OF WEALTH

Required:

Discuss the extent to which the concept of maximisation of wealth is relevant to the formulation of company financial objectives. In doing this, you should make reference to a valuation formula based on dividend growth and to the importance of statistics of earnings per share. (25 marks)

LE CTURE R RESO URCE P ACK – Q UEST IO NS

KAP LA N P UBL IS HI NG 3

TWO ORGANISATIONS

This question concerns two organisations, one in the private sector and one in the public sector.

Organisation 1

This is a listed company in the electronics industry. Its stated financial objectives are:

‘to increase earnings per share year-on-year by 10% per annum’

‘to achieve a 25% per annum return on capital employed’.

This company has an equity market capitalisation of $600 million. It also has a variety of debt instruments trading at a total value of $150 million.

Organisation 2

This organisation is a newly-established purchaser and provider of healthcare services in the public sector. The organisation’s legal status is a Trust.

Its total income for the current year will be almost $100 million. The Trust’s sole financial objective states simply ‘to achieve financial balance during the year’. Its other objectives are concerned with qualitative factors such as ‘providing high quality healthcare’.

Required:

Discuss:

(i) the reasons for the differences in the financial objectives of the two types of organisation given above

(ii) the main differences in the risks involved in the achievement of their financial objectives and how these risks might be managed.

Use the scenario details given above to assist your answer wherever possible.

(Total: 25 marks)

PAPE R F 9 : F I NA NCIA L MA NAG EM ENT

4 KAP LA N P UBL IS HI NG

PLANKERS INC

Assume that ‘now’ is June 20X3.

You are in charge of developing long term plans for your business, Plankers Inc. Plans are developed on the basis that the business has a single objective and seeks to maximise its profits as measured by profit after tax.

The company has a loan facility from its bank of $8m at 8% annually. The outstanding liability at 31 May 20X3 is $7m. It is possible to extend the facility up to $12m but only at an interest cost of 9% on the whole outstanding balance. The condition attached to this loan is that interest cover should at least be equal to 3: that is, profit before interest and tax (PBIT) should be at least three times the interest. If the condition is breached then the loan becomes repayable immediately.

Interest charges in the income statements are calculated on year-end balances (at 31 May each year). For example, interest charges in the year-end 31 May 20X3 income statement were based on year-end balances at 31 May 20X3.

Targets set by the directors of Plankers are as follows:

(1) cash balance must not fall below $1m, and

(2) it is desirable that Basic Earnings per Share should not fall below 20¢ per share. The company has in issue 4m $1 ordinary shares.

The constraint set by the bank and the targets set by the directors are measured and assessed at each year-end. The summary income statement for the year just ended (31 May 20X3) and a summary balance sheet (statement of financial position) are shown below along with forecasts for the next 2 years:

31 May 20X3 31 May 20X4 31 May 20X5

$m $m $m

PBIT 1.71 1.80 1.89

Interest charges (0.56)

____

(0.56)

____

(0.56)

____

Profit before tax 1.15 1.24 1.33

Tax (0.35)

____

(0.37)

____

(0.40)

____

Profit after tax 0.80

____

0.87

____

0.93

____

Dividends 0.40 0.44 0.47

Retained profit 0.40 0.43 0.46

Non-cash net assets 5.25 5.57 5.91

Cash 8.25 8.36 8.48

Loan liabilities (7.00)

____

(7.00)

____

(7.00)

____

Shareholders’ funds 6.50

____

6.93

____

7.39

____

LE CTURE R RESO URCE P ACK – Q UEST IO NS

KAP LA N P UBL IS HI NG 5

Forecasts are based on the assumption that PBIT is likely to grow at a rate of 5% per annum. The forecasts of PBIT growth include the effect of the building programme and the depreciation on it. The corporation tax rate is 30%.

The company is planning a major building programme on 1 June 20X5 at which time a cash outflow of $12m would have to be paid. 50% of this expenditure will be depreciated at the rate of 15% per annum (the company has no other depreciable assets). This depreciation has been agreed as allowable for tax purposes with the tax authorities.

The directors of Plankers are considering utilising the loan facility to help meet the funding requirements of the building programme, but are wondering whether their targets will be met or whether the loan conditions will be breached. They have asked you to conduct an analysis of the company’s financial position at 31 May 20X6 assuming the building programme begins on the 1 June 20X5. For 20X6 only, the company will not pay any dividends to minimise its refinancing needs.

Required:

(a) (i) Prepare a forecast summary income statement for the year to 31 May 20X6 assuming that the building programme is undertaken at 1 June 20X5 and that any additional funds are provided by an extension of the bank loan.

Assume that tax is paid in the year in which incurred.

Work to 3 decimal places of $m in your answer. (5 marks)

(ii) Assess whether, at 31 May 20X6 and based on the scenario in (i) above, the loan condition would be breached and whether the directors’ targets would be achieved.

Work to 3 decimal places of $m in your answer. (3 marks)

(iii) Identify 5 options the company could use, assuming it faced a cash shortfall, to ease any cash shortage. (5 marks)

(iv) Explain, without further computations, whether each of the options in (a) (iii) is likely to meet Planker’s requirements for additional capital and also the constraint set by the bank. (3 marks)

(b) Whilst the financial plans of the business are based on a single objective, it faces a number of constraints that put pressure on the company to address more than one objective simultaneously.

Required:

What types of constraints might the company face when assessing its long-term plans? Specifically refer in your answer to:

(i) responding to various stakeholder groups, and (4 marks)

(ii) the difficulties associated with managing organisations with multiple objectives. (5 marks)

(Total: 25 marks)

PAPE R F 9 : F I NA NCIA L MA NAG EM ENT

6 KAP LA N P UBL IS HI NG

BRETT

Brett is an established company, selling high quality products. Sales and profit growth have been strong over the past few years, and the directors have been investigating various plans for further growth.

Brett’s Income Statement for the year ended 31 October 20X6 and Statement of Financial Position as at that date are summarised below:

Statement of Financial Position as at 31 October 20X6

$m $m $m

Non-current assets 45.0

Current assets:

Inventory 20.0

Accounts receivable 5.0

Cash 5.0

____

30.0

____

Total assets 75.0

____

Equity and liabilities

Issued share capital (par value 50c) 4.0

Share premium reserve 4.0

Profit and loss reserve 31.0

____

Total equity 39.0

Non-current liabilities:

10% debenture 8.0

Bank loan (12%) 4.0

____

12.0

Current liabilities:

Accounts payable 24.0

_____

75.0

____

LE CTURE R RESO URCE P ACK – Q UEST IO NS

KAP LA N P UBL IS HI NG 7

Income statement for the year ended 31 October 20X6

$m

Revenue 120.0

Cost of sales and expenses (105.0)

_____

Operating profit 15.0

Interest (1.3)

_____

Profit before tax 13.7

Tax (at 30%) (4.1)

_____

Profit after tax 9.6

Dividends (3.8)

_____

Retained earnings 5.8

_____

Notes to the accounts:

(1) Depreciation of non-current assets is on a straight-line basis, and is currently $5.0m per annum.

(2) Cost of sales is made up as follows:

Variable cost of sales $75m

Fixed operating cost $25m

Depreciation $5m

_____

Total $105m

It has now been decided to expand into a new market. The non-current asset investment is expected to cost $10m; $4m of this is to be financed by retained earnings using the existing cash resource. The other $6m is to be financed with a 1 for 8 rights issue. The rights shares will be priced at a 25% discount on the current share price of $8.

The expansion is expected to increase sales by 30%, and the increased sales are expected to have the same contribution to sales (C/S) ratio as the existing sales. Fixed operating costs are expected to increase by $4m and depreciation on the new investment is $2m per annum. Brett intends to maintain its dividend payout proportion. Inventory, accounts payable and receivable are all expected to increase in proportion to sales.

The following information is available regarding industry average key financial indicators for 20X6:

Return on capital employed 18%

Return on equity 15.8%

Operating profit margin 10%

Current ratio 1.25:1

Acid test ratio 1.1:1

PAPE R F 9 : F I NA NCIA L MA NAG EM ENT

8 KAP LA N P UBL IS HI NG

Gearing (debt/equity) 33%

Interest cover 6.0

Dividend cover 3.0

PE ratio 6.0

Dividend yield 8%

Required:

(a) Prepare a report for the directors of Brett, discussing their performance for the year ended 31 October 20X6. (14 marks)

(b) Prepare a forecast income statement for Brett for the year ending 31 October 20X7. (4 marks)

‘Private sector companies such as Brett have multiple stakeholders who are likely to have divergent interests.’

(c) Identify three stakeholder groups and briefly discuss their financial and other objectives. Relate your comments to the statement above. (7 marks)

(Total: 25 marks)

LE CTURE R RESO URCE P ACK – Q UEST IO NS

KAP LA N P UBL IS HI NG 9

BANKS AND FISCAL POLICY

(a) Explain the process whereby commercial banks can create the short-term credit required by business and other borrowers, and the constraints on this process. (15 marks)

(b) Identify, and briefly explain, the nature of two problems associated with the use of fiscal policy to control cyclical variations in the macro-economy. (10 marks)

(Total: 25 marks)

PAPE R F 9 : F I NA NCIA L MA NAG EM ENT

10 KAP LA N P UBL IS HI NG

Z INDUSTRIES

Z Industries is an operating subsidiary of a large quoted company. Group management makes use of net current asset and liquidity ratios to evaluate period-end Statements of Financial Position. There is concern that the control exercised by Z Industries over its working capital is less than adequate.

The parent company establishes targets for inventories, receivables and payables and monitors how the subsidiary achieves those targets. For Z Industries it expects:

(1) inventories to be no more than 10% of sales;

(2) receivables to be equal to no more than 2½ months’ credit sales;

(3) payables to be equal to no less than 2½ months’ purchases.

Cash is subject to control limits. Money is put on short-term deposit when holdings exceed 110% of target. This target is the residual arrived at by reference to group norms for the net current assets ratio after the targets referred to above have been applied. When cash holdings drop below 90% of target, withdrawal is made from interest-bearing accounts to meet the target holding.

Required:

(a) Discuss what shortcomings are inherent in the adoption of the above criteria; (10 marks)

(b) Explain how the setting of a working capital target based on actual sales turnover may be more or less appropriate than that based on a forecast; (10 marks)

(c) Suggest how receivables balances may be monitored more appropriately. (5 marks)

(Total: 25 marks)

LE CTURE R RESO URCE P ACK – Q UEST IO NS

KAP LA N P UBL IS HI NG 11

FRANTIC

Frantic Co is a specialist car manufacturer and is a member of a group of companies that provides a range of automobile products and services. It is currently facing difficulties in the management of its working capital and the financial controller of Frantic Co is to investigate the situation with a view to optimising supplier payments and customer discounts to ease projected cash flow problems.

Payables

Payables arise only for engine purchases. Engine suppliers have offered an early settlement discount of 1.5% if invoices are settled within one month of delivery. If the settlement discount is not taken, normal payment terms of two months from delivery apply.

Receivables

The cars are sold at $42,500 each and unit sales are equal to the units produced in each month. 50% of the cars are made to order and payment is on a ‘cash on delivery’ basis. The remaining cars are sold to specialist retailers who take two months’ credit. Frantic is considering offering the specialist retailers a 2% discount for payments made within one month of sale. It is expected that 75% of the retailers would take up the offer.

The company uses its bank overdraft rate of 15% as its discount rate.

Required:

(a) Calculate:

(i) if it is beneficial for Frantic to change from a two month payment period to a one month payment period for payables (3 marks)

(ii) if it is beneficial for Frantic to implement the 2% discount for receivables.

(2 marks)

(b) Write a report to the Managing Director which identifies:

– how cash flow problems can arise

– the methods available for easing cash shortages

– the techniques, besides cash budgeting, that could be used to monitor and manage cash resources

– the benefits of centralising cash management in a treasury department for group companies. (20 marks)

In all your answers clearly state any assumptions you make. (Total: 25 marks)

PAPE R F 9 : F I NA NCIA L MA NAG EM ENT

12 KAP LA N P UBL IS HI NG

WHICHFORD CO

The $25 million annual credit sales of Whichford Co are spread evenly over each of the 50 weeks of the working year. Sales within each week are also equally spread over each of the five working days.

Although Whichford operates from 19 separate locations, all invoicing of credit sales is carried out by the central head office. Sales documentation is sent by post daily from each location to the head office and from these details invoices are prepared. Postal delays affecting the receipt of documentation by the head office, delays and bottlenecks in processing at head office, together with the intervention of the non-working weekend period, all contribute to the considerable range of delays in despatching invoices. As a result of these delays only some of the sales made on Mondays and Tuesdays of each week are invoiced that same week, the remainder of sales made on Mondays and Tuesdays and all sales made between Wednesdays, Thursdays and Fridays are not invoiced until the following week.

An analysis of the delay in invoicing, measured by the delay between the day of sale and the date of despatch of the invoice, indicated the following typical pattern:

No. of days’ delay in invoicing Percentage of week’s sales subject to this delay

3 20%

4 6%

5 40%

6 22%

7 12%

A further analysis indicated that debtors take, on average, 35 days’ credit before paying. This period is measured from the day of the despatch of the invoice rather than from the date of sale.

It is proposed to hire a number of computers to undertake invoicing at each of the 19 sales locations. The use of computers would ensure that all invoices were despatched either on the day of sale or on the next working day. The revised invoicing would result in 50% of invoices being despatched with no delay, 40% subject to a delay of one day, and 10% subject to a delay of three days.

A computer package, currently in the final stages of development, would assist the follow-up of debtors and, if used, is likely to reduce the number of days’ credit taken by customers to 30 – again this is measured from the date of the invoice.

Use of the computers would save head office and postage costs of $48,000 p.a. spread evenly over the year.

Whichford finances all working capital from a bank overdraft at an interest rate of 15% p.a. applied on a simple daily basis.

Required:

(a) Ignoring taxation, determine the maximum monthly rental that Whichford should consider paying for the hire of the computers if they can be used:

(i) only to speed the invoicing function;

(ii) to speed invoicing and reduce the period of credit taken from 35 to 30 days following the despatch of an invoice. (15 marks)

LE CTURE R RESO URCE P ACK – Q UEST IO NS

KAP LA N P UBL IS HI NG 13

(b) Describe the main characteristics and features of a factoring agreement.

Clearly distinguish between factoring and invoice discounting. Outline the main issues which should be given consideration before entering into a factoring agreement and illustrate the circumstances in which entering into a factoring agreement may be desirable. (10 marks)

(Total: 25 marks)

PAPE R F 9 : F I NA NCIA L MA NAG EM ENT

14 KAP LA N P UBL IS HI NG

TRADE CREDIT

(a) Payables are commonly used as a major source of short-term finance.

Required:

Explain what factors might be taken into account by an enterprise in deciding the extent to which it should make use of credit from suppliers. (5 marks)

(b) Required:

(1) Calculate the annualised cost of trade credit under the following four circumstances, the normal terms of payment being 30 days net in every case; and

(2) State what conclusions you draw about the desirable period of credit to be taken in each case;

(i) the supplier imposes a fixed penalty for late payment, of 2% per month on the invoice value;

(ii) the supplier charges simple interest at 2% per 30-day period after the due date;

(iii) the supplier charges 2% compound interest per 30-day period after the due date;

(iv) 2% discount is offered for payment within ten days from the date of the invoice.

Assume a 365-day year. (16 marks)

(c) From the point of view of the supplier, a gain of two days in the availability of funds could be achieved by asking his bankers for special clearance of remittances.

If the charge for this service was $2.50 and the supplier’s opportunity cost of capital was 10%, calculate the minimum remittance value for which this procedure would be beneficial. (4 marks)

(Total: 25 marks)

LE CTURE R RESO URCE P ACK – Q UEST IO NS

KAP LA N P UBL IS HI NG 15

SPECIAL GIFT SUPPLIES INC

Special Gift Supplies Inc is a wholesale distributor of a variety of imported goods to a range of retail outlets. The company specialises in supplying ornaments, small works of art, high value furnishings (rugs, etc) and other items that the chief buyer for the company feels would have a domestic market. In seeking to improve working capital management, the financial controller has gathered the following information.

Months

Average period for which items are held in inventory 3.5

Average receivables collection period 2.5

Average payables payment period 2.0

Required:

(a) Calculate Special Gift Supplies’ funding requirements for working capital measured in terms of months. (2 marks)

(b) In looking to reduce the working capital funding requirement, the financial controller of Special Gift Supplies is considering factoring credit sales. The company’s annual turnover is $2.5m of which 90% are credit sales. Irrecoverable debts are typically 3% of credit sales. The offer from the factor is conditional on the following:

(1) The factor will take over the sales ledger of Special Gift Supplies completely.

(2) 80% of the value of credit sales will be advanced immediately (as soon as sales are made to the customer) to Special Gift Supplies, the remaining 20% will be paid to the company one month later. The factor charges 15% per annum on credit sales for advancing funds in the manner suggested. The factor is normally able to reduce the receivables’ collection period to one month.

(3) The factor offers a ‘no recourse’ facility whereby they take on the responsibility for dealing with irrecoverable debts. The factor is normally able to reduce irrecoverable debts to 2% of credit sales.

(4) A charge for factoring services of 4% of credit sales will be made.

(5) A one-off payment of $25,000 is payable to the factor.

The salary of the Sales Ledger Administrator ($12,500) would be saved under the proposals and overhead costs of the credit control department, amounting to $2,000 per annum, would have to be reallocated. Special Gift Supplies’ cost of overdraft finance is 12% per annum. Special Gift Supplies pays its sales force on a commission only basis. The cost of this is 5% of credit sales and is payable immediately the sales are made. There is no intention to alter this arrangement under the factoring proposals.

Required:

Evaluate the proposal to factor the sales ledger by comparing Special Gift Supplies’ existing receivables collection costs with those that would result from using the factor (assuming that the factor can reduce the receivables’ collection period to one month). (8 marks)

PAPE R F 9 : F I NA NCIA L MA NAG EM ENT

16 KAP LA N P UBL IS HI NG

(c) As an advisor to Special Gift Supplies Inc, write a report to the financial controller that outlines:

(i) how a credit control department might function

(ii) the benefits of factoring and

(iii) how the financing of working capital can be arranged in terms of short and long-term sources of finance.

In particular, make reference to: the financing of working capital when short-term sources of finances are exhausted; and the distinction between fluctuating and permanent current assets. (15 marks)

(Total: 25 marks)

LE CTURE R RESO URCE P ACK – Q UEST IO NS

KAP LA N P UBL IS HI NG 17

WORKING CAPITAL

‘Working capital and its management is a key factor in the company’s long-term success, since without the ‘oil’ of working capital the ‘engine’ of fixed assets will be unable to function.’

Watson and Head, in Corporate Finance Principles and Practice.

Required:

(a) Explain the importance of working capital management. (6 marks)

(b) Suggest ways in which companies can exercise control over their levels of working capital. (8 marks)

(c) Explain the cash conversion cycle (operating cycle) and its significance in determining the working capital needed by a company. (5 marks)

(d) Explain the different strategies a firm may follow in order to finance its working capital requirements. (6 marks)

(Total: 25 marks)

PAPE R F 9 : F I NA NCIA L MA NAG EM ENT

18 KAP LA N P UBL IS HI NG

FILLS FOOTBALLS CO

Fills Footballs Co is considering the use of debt factoring. Currently, the company’s annual turnover is $750,000. All sales are on credit and on average, debtors take 45 days to pay. Bad debts are about 1% of revenue.

A factor has proposed to take on the task of debt collection on a no recourse basis, but would want to administer the sales ledger, for which it would charge an annual fee of 3% of revenue. The factor has expressed the view that it would expect to reduce the average debt collection period to 35 days and to reduce bad debts to 0.25% of revenue. The factor would also advance finance to Fills Footballs equal to 80% of uncollected debts, and would charge interest at 9% on the money advanced. Fills Footballs currently has a bank overdraft, on which it is paying interest at 10% per annum. It has been estimated that if the factor takes over the sales ledger administration, Fills Footballs would save annual operating expenses of $20,000.

Required:

(a) Recommend, with supporting calculations, whether the company should take up the debt factor’s offer. (8 marks)

(b) Write a report to management explaining:

(i) credit control procedures

(ii) other methods of improving debt collection, if the factor is not used

(iii) the importance to a company of careful debtor management. (17 marks)

(Total: 25 marks)

LE CTURE R RESO URCE P ACK – Q UEST IO NS

KAP LA N P UBL IS HI NG 19

BORROWING CO

Whilst setting its long-term budget for the years ended 31 December 20X1 to 31 December 20X9, Borrowing Co has reviewed the costs attributable to each cost centre. The firm is concerned with the cost forecasts for centre CS/23/CS, namely the circular saw. The cost budget for the next five years is:

Year ended 31.12.X1 31.12.X2 31.12.X3 31.12.X4 31.12.X5 $000 $000 $000 $000 $000

Depreciation 211 158 119 89 67 Supervision salary 500 600 720 864 1,037 Power 15 15 20 20 25 Insurance 5 5 10 10 15 Consumable stores 130 150 180 220 270 Maintenance – labour 800 1,000 1,200 1,500 1,900 – parts 550 830 1,090 1,500 1,790 Fixed overheads absorbed 200 250 300 350 450

The charge for insurance is in respect of a policy which specifically relates to the saw. The supervisor only spends a portion of his time with the saw – when it is being used by apprentices. The saw is currently (31 December 20X0) valued at $750,000, although this figure is expected to fall by $250,000 each year.

A new saw has come onto the market which is being offered at $3,500,000. As a sales promotion idea the firm selling the saw has promised that its first 100 customers may purchase all future saws at the same price. The running costs of the new saw are expected to be:

Year ended 31.12.X1 31.12.X2 31.12.X3 31.12.X4 31.12.X5 $000 $000 $000 $000 $000

Labour 300 475 650 700 800 Parts 200 300 400 500 600 Other direct costs 500 600 700 800 900 Fixed overheads absorbed 300 350 400 450 500

The scrap value of the new saw is estimated as being $2,000,000 at the end of its first year’s use, $1,500,000 after two years, $1,000,000 after three years, $250,000 after four years and from then on the asset would have negligible scrap value.

Required:

(a) Determine how often the new machine should be replaced;

(b) Determine when the old machine should be replaced.

Ignore taxation and assume that this type of machine will be used in perpetuity.

Borrowing Co has a required rate of return of 10%. (25 marks)

PAPE R F 9 : F I NA NCIA L MA NAG EM ENT

20 KAP LA N P UBL IS HI NG

HAWESWATER

(a) Haweswater is a transport company whose ‘cost of money’ is 15.5%.

In December 20X1 price inflation in the United Kingdom is at a rate of 10% per year and this rate is expected to continue for the next 10 years.

In January 20X2 Haweswater is considering the purchase of a new truck which will be required to travel 50,000 km per year. Two suitable models are available, details of which are as follows:

The Model K, which has a life of 4 years and a price of £24,000;

– the running cost is 21 pence per km but this figure will rise by 5 pence per km for each year the truck is in service;

– a new engine (cost £6,000) will have to be fitted at the end of the second year in which the truck has been in service.

The Model S, which has a life of 6 years and a price of £42,000;

– the running cost is initially 18 pence per km but this figure will rise by 3.6 pence per km for each year the truck is in service.

All costs quoted are at January 20X2 price levels.

Required:

Advise Haweswater’s management as to which truck (Model K or Model S) Haweswater should buy. You should assume that Haweswater is not in a tax paying position and will not be so during the next 10 years. Support your advice with a full financial analysis. (10 marks)

(b) In addition to the information given in (a), you are informed Haweswater is now in a tax paying position and is expected to remain so for the next 10 years.

There is 35% tax on corporate profits with ‘Writing Down Allowances’ in respect of equipment being 25% per year on a reducing balance basis. The cost of spare parts is treated as revenue expenditure for tax purposes. The post-tax money cost of capital is 10%. You may assume that tax is payable 12 months after the end of the financial year in which the associated profits were earned. Haweswater’s financial year ends on 31 December.

Required:

Advise Haweswater’s management as to which truck it should buy, incorporating this additional information in your calculations. Support your advice with a full financial analysis. (10 marks)

(c) Required:

Explain the likely effects on the level and nature of investment in the economy if the tax system were altered to allow expenditure on equipment to be set fully against taxable income in the year that such expenditure is incurred. (5 marks)

(Total: 25 marks)

LE CTURE R RESO URCE P ACK – Q UEST IO NS

KAP LA N P UBL IS HI NG 21

NESPA

Nespa is a profitable medium-sized toy manufacturer that has been listed on a stock exchange for three years. Although the company has an overdraft, it has no long-term debt and its current interest cover is high compared to similar companies. Its return on capital employed, however, is close to the average for its business sector. One of its machines is leased under an operating lease, but the company has no other leasing or hire purchase commitments. The company owns two factories and the land on which they are built, as well as a small fleet of delivery vehicles. The company does not own any retail outlets through which to distribute its manufactured output.

Nespa is considering an investment in a new machine, with a maximum output of 200,000 units per annum, in order to manufacture a new toy. Market research undertaken for the company indicated a link between selling price and demand, and the research agency involved has suggested two sales strategies that could be implemented, as follows:

Strategy 1 Strategy 2

Selling price (in current price terms) $8.00 per unit $7.00 per unit

Sales volume in first year 100,000 units 110,000 units

Annual increase in sales volume after first year 5% 15%

The services of the market research agency have cost $75,000 and this amount has yet to be paid.

Nespa expects economies of scale to reduce the variable cost per unit as the level of production increases. When 100,000 units are produced in a year, the variable cost per unit is expected to be $3.00 (in current price terms). For each additional 10,000 units produced in excess of 100,000 units, a reduction in average variable cost per unit of $0.05 is expected to occur. The average variable cost per unit when production is between 110,000 units and 119,999 units, for example, is expected to be $2.95 (in current price terms); and the average variable cost per unit when production is between 120,000 units and 129,999 units is expected to be $2.90 (in current price terms), and so on.

The new machine would cost $1,500,000 and would not be expected to have any resale value at the end of its life. Capital allowances would be available on the investment on a 25% reducing balance basis. Although the machine may have a longer useful economic life, Nespa uses a five-year planning period for all investment projects. The company pays tax at an annual rate of 30% and settles tax liabilities in the year in which they arise.

Operation of the new machine will cause fixed costs to increase by $110,000 (in current price terms). Inflation is expected to increase these costs by 4% per year. Annual inflation on the selling price and unit variable costs is expected to be 3% per year. For profit reporting purposes Nespa depreciates machinery on a straight-line basis over its planning period.

Nespa applies three investment appraisal methods to new projects because it believes that a single investment appraisal method is unable to capture the true value of a proposed investment. The methods it uses are net present value, internal rate of return and return on capital employed (accounting rate of return). The company believes that net present value measures the potential increase in company value of an investment project: that a high internal rate of return offers a margin of safety for risky projects; and that a project’s before-tax return on capital employed should be greater than the company’s before-tax return on capital employed, which is 20%. Nespa does not use any explicit method of assessing project risk and has an average cost of capital of 10% in money (nominal) terms.

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The company has not yet decided on a method of financing the purchase of the new machine, although the finance director believes that a new issue of equity finance is appropriate given the amount of finance required.

Required:

(a) Determine the sales strategy which maximizes the present value of total contribution. Ignore taxation in this part of the question. (8 marks)

(b) Evaluate the investment in the new machine using internal rate of return.

(12 marks)

(c) Evaluate the investment in the new machine using return on capital employed (accounting rate of return) based on the average investment. (5 marks)

(Total: 25 marks)

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THE INDEPENDENT FILM COMPANY

The Independent Film Company is a film distribution company which purchases distribution rights on films from small independent producers, and sells the films on to cinema chains for national and international screening. In recent years the company has found it difficult to source sufficient films to maintain profitability. In response to the problem, the Independent Film Company has decided to invest in commissioning and producing films in its own right. In order to gain the expertise for this venture, the Independent Film Company is considering purchasing an existing filmmaking concern, at a cost of $400,000. The main difficulty that is anticipated for the business is the increasing uncertainty as to the potential success/failure rate of independently produced films. Many cinema chains are adopting a policy of only buying films from large international film companies, as they believe that the market for independent films is very limited and specialist in nature. The Independent Film Company is prepared for the fact that they are likely to have more films that fail than that succeed, but believe that the proposed film production business will nonetheless be profitable.

Using data collected from the existing distribution business and discussions with industry experts, they have produced cost and revenue forecasts for the five years of operation of the proposed investment. The company aims to complete the production of three films per year. The after tax cost of capital for the company is estimated to be 14%.

Year 1 sales for the new business are uncertain, but expected to be in the range of $4 million – $10 million. Probability estimates for different forecast values in Year 1 are as follows:

Sales ($ million) Probability

4 0.2

5 0.4

7 0.3

10 0.1

Sales are expected to grow at an annual rate of 5%.

Anticipated costs related to the new business in Year 1 are as follows:

Cost type $000

Purchase of film-making company 400

Annual legal and professional costs 20

Annual lease rental (office equipment) 12

Studio and set hire (per film) 180

Camera/specialist equipment hire (per film) 40

Technical staff wages (per film) 520

Screenplay (per film) 50

Actors’ salaries (per film) 700

Costumes and wardrobe hire (per film) 60

Set design and painting (per film) 150

Annual non-production staff wages 60

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Additional information

(1) No capital allowances are available.

(2) Tax is payable one year in arrears, at a rate of 33%, and full use can be made of tax refunds as they fall due.

(3) Staff wages (technical and non-production staff) and actors’ salaries, are expected to rise by 10% per annum.

(4) Studio hire costs will be subject to an increase of 30% in Year 3.

(5) Screenplay costs per film are expected to rise by 15% per annum due to a shortage of skilled writers.

(6) The new business will occupy office accommodation which has to date been let out for an annual rent of $20,000. Demand for such accommodation is buoyant and the company anticipates no problems in finding future tenants at the same annual rent.

(7) A market research survey into the potential for the film production business cost $25,000.

Required:

(a) Using DCF analysis, calculate the expected Net Present Value of the proposed investment. (Workings should be rounded to the nearest $000.) (18 marks)

(b) Outline the main limitations of using expected values when making investment decisions. (7 marks)

(Total: 25 marks)

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AMBER PLC

Amber plc operates a daily return high-speed train service between the UK and mainland Europe, via the Channel Tunnel. In an attempt to reduce overheads, the company is considering using an outside supplier to take over responsibility for all on-train catering services. Amber invited tenders for a five-year contract, and at the same time the senior management accountant drafted a schedule of costs for in-house provision of an equivalent service. This cost schedule, together with the details of the lowest price tender which was received, are given below (see Table 1 and additional information).

Table 1: In-house provision of train catering services

Schedule of costs, Amber plc

Pence per £ sales revenue

Variable costs

Direct material 55

Variable overhead 12

Fixed costs (allocated to products)

Labour (Year 1) 10

Purchase/storage management 3

Depreciation (catering equipment) 4

Insurance 2

__

Total cost 86

__

The train service operates 360 days per year and a single restaurant carriage is adequate to service the catering needs of a train carrying up to 600 passengers. The tendered contract (and the in-house schedule of costs) is for the provision of one catering carriage per train. Past sales data indicate that 45% of passengers will use the catering service, spending an average of £4.50 each per single journey or £9.00 per return journey. This is expected to remain unchanged over the next five years, unless Amber invests in quality improvements.

Statistical forecasts of the level of demand for the train service, under differing average weather conditions and average exchange rates over the next five years, are shown in Table 2.

Table 2: Forecast passenger figures (per single journey)

UK weather conditions

Exchange rate: € per £1 Poor Reasonable Good

1.52 500 460 420

1.54 550 520 450

1.65 600 580 500

The differing weather conditions are all assumed to be equally likely.

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Based on historical trends, the probability of each different exchange rate occurring is estimated as follows:

Exchange rate € per £1 Probability

1.52 0.2

1.54 0.5

1.65 0.3

Additional information

(i) Labour costs are expected to rise at a rate of 5% per year over the next five years.

(ii) Variable costs per £ sales revenue are expected to remain unchanged over the next five years.

(iii) Some catering equipment will need to be replaced at the end of Year 2 at a cost of £500,000. This would increase the depreciation charge on catering equipment to 5 pence per £ sales revenue. The equipment value at the end of Year 5 is estimated to be £280,000.

(iv) The outside supplier (lowest price tender) has agreed to purchase immediately (for cash) the existing catering equipment owned by Amber plc at a price equal to the current book value, i.e. £650,000. The supplier would charge Amber a flat fee of £250 per day for the provision of this catering service, and Amber would receive 5% of gross catering receipts where these exceeded an average of £2,200 per day in each 360-day period. The quality of the catering service is expected to be unaffected by the contracting out.

(v) In the event of Amber deciding to contract out the catering, the following fixed costs will be saved:

Depreciation £35,000 per year

Purchasing/storage costs £18,000 per year

Insurance £3,000 per year

Labour costs £74,844 (Year 1)

(vi) The cost of capital for Amber plc is 12%.

Assume that all cash flows occur at the end of each year. Taxation may be ignored in answering this question.

Required:

(a) Calculate the expected number of passengers per single journey for the train service. (4 marks)

(b) Draft a table of annual cash flows and, using discounted cash flow analysis, determine which of the two alternatives (in-house provision or contracting out) is preferred. (16 marks)

(c) Calculate and comment upon the financial effect on the decision of a forecast 10% increase in the number of passengers purchasing food and beverages on each train if the in-house catering service were to be improved. Any such improvement would require Amber investing £10,000 per year over five years on staff training. (5 marks)

(Total: 25 marks)

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WATER SUPPLY SERVICES INC

Water Supply Services Inc is a small regional supplier of water to domestic premises. The company has been operating for a number of years. Its sole customer is the Regional Water Authority (RWA), which allows the company to charge a 25% mark up of agreed costs. The agreed costs that can be incorporated into any calculation of mark up are only labour costs, materials costs, variable overheads, fixed overheads and machine rentals.

Water Supply Services has been approached by RWA with a proposal to increase output to meet a further domestic customer base not previously supplied with water. The company would have to increase its capacity to meet this demand and increased demand from existing customers. Water output is measured in units, with each unit being 1,000 litres. Water Supply Services is currently operating at capacity which is 80,000 units per annum as determined by processing capability.

Increasing processing capability would require the rental of further machines that are involved in the chemical cleaning of water. There is an overall maximum capacity of 200,000 units beyond which the company cannot produce water because of physical limitations of its production site. Each water-cleaning machine has the following rental and unit capacity details.

Water cleaning machine

Annual rental ($) 22,000

Maximum annual capacity (units) 45,000

Water Supply Services has an existing budgeted direct cost structure based on its current level of output of 80,000 units, as follows:

$/unit

Labour grade 1 45.00

Labour grade 2 64.00

Material A costs 23.85

Material B costs 62.25

Variable overheads (electricity, maintenance etc.) are absorbed at the rate of $2 per kg of material B used. 5kg of material B is used in the manufacture of 1,000 litres of water. Fixed overheads are based on an existing output of 80,000 units and are absorbed at the rate of $10.20 per unit. Above 160,000 units, fixed overheads would be expected to increase at the rate of $50,000 per annum for every additional 40,000 units produced, or part thereof.

The existing agreement that Water Supply Services will charge a 25% mark up of agreed costs will apply for this proposal. The acceptance of this proposal would not affect any charges relating to the existing supply of 80,000 units.

Domestic demand for water in the next year, if the customer base is expanded, is estimated to total 110,000 units rising by 15% per annum thereafter. This level of demand growth is expected to continue for the foreseeable future.

Working capital requirements are estimated at 15% of sales value and are required to be in place at the start of the period to which the sales relate. Capital investment of $7.5m would be required in order to provide the necessary support facilities to expand capacity to 200,000 units per annum. Thereafter, updating costs of $30,000 would be required at the end of every four years. The cost of capital used in appraising projects is 20% per annum.

All sales and costs should be assumed to arise at the end of the year unless otherwise identified. Ignore the impact of taxation in your answer.

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Required:

(a) Evaluate the proposal to expand capacity using present value methods. Make your evaluation on the basis of a five-year period only.

Express all calculations in this part of the question to the nearest $1,000. You are advised to state any assumptions made. (18 marks)

(b) In your capacity as Senior Accountant, draft a report to the Board of Directors that considers the following:

(i) the choice of an appropriate discount rate, and

(ii) any non-quantifiable factors you feel might influence the decision to accept the proposal. (7 marks)

(Total: 25 marks)

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HYDEN

Hyden is a new company and wishes to make its first issue of shares via an offer for sale by tender. A total of 12 million shares are being offered and the twin objectives of the tender offer are:

(1) to raise the maximum sum for Hyden’s initial investors; and

(2) to obtain a good range of at least 5,000 shareholders including many small, private investors as well as institutional investors.

The following tenders have been received:

Price No. of shares applied No. of applicants tendered for at this price at this price per share (see note) $ million 8.0 0.10 10 7.0 0.30 40 6.0 0.60 80 5.0 1.00 170 4.5 2.00 300 4.0 3.00 600 3.5 5.00 800 3.0 8.00 3,000 2.5 12.00 4,000 2.0 4.00 2,000

Note: Each applicant has made only one offer. No multiple applications have been received.

Hyden is uncertain whether:

(1) to accept in full the offers which will maximise the funds raised; or

(2) to partially accept the minimum number of offers which will result in 5,000 shareholders. Partial acceptance would mean allotting to each accepted applicant an equal proportion of the shares applied for.

One investor, PJ Coates, has applied for 10,000 shares at a price of $5 per share and has despatched a cheque for $50,000 to the issuing house dealing with Hyden’s issue.

Required:

(a) Determine for each of the two specified approaches to acceptance of the tender offers:

(i) the total gross funds raised by Hyden

(ii) for the investor PJ Coates:

(1) the number of shares issued to him; and

(2) the amount of any cheque he might expect to receive from Hyden as partial repayment of the original amount paid by him. (15 marks)

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(b) Describe the merits and disadvantages of having a wide range of shareholders.

(5 marks)

(c) Describe a rights issue and a placing and to compare both these methods of raising equity capital with an offer for sale by tender. Describe the circumstances where the use of each of these three methods of issuing equity would be appropriate. (5 marks)

(25 marks)

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NETHERBY PLC

Netherby plc manufactures a range of camping and leisure equipment, including tents. It is currently experiencing severe quality control problems at its existing fully-depreciated factory in the south of England. These difficulties threaten to undermine its reputation for producing high quality products. It has recently been approached by the European Bank for Reconstruction and Development, on behalf of a tent manufacturer in Hungary, which is seeking a UK-based trading partner which will import and distribute its tents. Such a switch would involve shutting down the existing manufacturing operation in the UK and converting it into a distribution depot. The estimated exceptional restructuring costs of £5m would be tax-allowable, but would exert serious strains on cash flow.

Importing, rather than manufacturing tents appears inherently profitable as the buying-in price, when converted into sterling, is less than the present production cost. In addition, Netherby considers that the Hungarian product would result in increased sales, as the existing retail distributors seem impressed with the quality of the samples which they have been shown. It is estimated that for a five-year contract, the annual cash flow benefit would be around £2m pa before tax.

However, the financing of the closure and restructuring costs would involve careful consideration of the financing options. Some directors argue that dividends could be reduced as several competing companies have already done a similar thing, while other directors argue for a rights issue. Alternatively, the project could be financed by an issue of long-term loan stock at a fixed rate of 12%.

The most recent balance sheet shows £5m of issued share capital (par value 50p), while the market price per share is currently £3. A leading security analyst has recently described Netherby’s gearing ratio as ‘adventurous’. Profit-after-tax in the year just ended was £15m and dividends of £10m were paid.

The rate of corporation tax is 33%, payable with a one-year delay. Netherby’s reporting year coincides with the calendar year and the factory will be closed at the year-end. Closure costs would be incurred shortly before deliveries of the imported product began, and sufficient stocks will be on hand to overcome any initial supply problems. Netherby considers that it should earn a return on new investment projects of 15% pa net of all taxes.

Required:

(a) Is the closure of the existing factory financially worthwhile for Netherby? (7 marks)

(b) Explain what is meant when the capital market is said to be information-efficient in a semi-strong form.

If the stock market is semi-strong efficient and without considering the method of finance, calculate the likely impact of acceptance and announcement of the details of this project to the market on Netherby’s share price. (6 marks)

(c) Advise the Netherby board as to the relative merits of a rights issue rather than a cut in dividends to finance this project. (8 marks)

(d) Assuming the restructuring proposal meets expectations, assess the impact of the project on earnings per share if it is financed by a rights issue at an offer price of £2 per share, and loan stock, respectively. (4 marks)

(You may ignore issue costs.)

(Total: 25 marks)

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DEBENTURES

(a) Required:

State the circumstances under which there could be advantages to lenders and to borrowers respectively from issues of:

(i) debentures with a floating rate of interest;

(ii) zero-coupon bonds.

Ignore taxation. (8 marks)

(b) A company is partly financed by 12% debentures, redeemable at par on 31 May 20X4. A lender seeking a 15% discounted rate of return is considering a £200 investment in these debentures on 1 June 20X1 immediately after payment of annual interest when the price of £100 debenture stock is expected to be £80.

Required:

Advise him whether he will obtain the required rate of return on his investment. (5 marks)

(c) A government body has to decide at what point in time it would be most advantageous, from the point of view of interest rate, to make an issue of long-term securities.

Assume that at the present moment the yield on index-linked gilts stands at 3¾%, the yield on long-dated government stocks is about 8% and the official forecast of the rate of inflation for the foreseeable future is between 3½% and 4%.

Required:

(i) Advise whether this would be a good or bad time to make a long-term issue. (6 marks)

(ii) Discuss the possible impact on interest rates of:

(1) changes in the level of consumer credit;

(2) forecasts of the balance of payments on current account;

(3) rumours of a parliamentary general election. (6 marks)

(Total: 25 marks)

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PRIME PRINTING CO

(a) Explain the cash flow characteristics of a finance lease, and compare it with the use of a bank loan or cash held on short-term deposit. Your answer should include some comment on the significance of a company’s anticipated tax position on lease versus buy decisions. (10 marks)

(b) Prime Printing Co has the opportunity to replace one of its pieces of printing equipment. The new machine, costing $120,000, is expected to lead to operating savings of $50,000 per annum and have an economic life of five years. The company’s after tax cost of capital for the investment is estimated at 15%, and operating cash flows are taxed at a rate of 30%, one year in arrears.

The company is trying to decide whether to fund the acquisition of the machine via a five-year bank loan, at an annual interest rate of 13%, with the principal repayable at the end of the five-year period. As an alternative, the machine could be acquired using a finance lease, at a cost of $28,000 p.a. for five years, payable in advance. The machine would have zero scrap value at the end of five years.

Note: Due to its current tax position, the company is unable to utilise any capital allowances on the purchase until year one.

Required:

Assuming that writing-down allowances of 25% p.a. are available on a reducing balance basis, recommend, with reasons, whether Prime Printing should replace the machine, and if so whether it should buy or lease. (15 marks)

(Total: 25 marks)

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BOLAR AND BOND YIELDS

Bolar Co currently has three types of marketable debt in its capital structure.

(i) Unsecured 14% bonds, redemption date 31 December 2009, with interest payable annually on 31 December. The current market price is $95 ex-interest.

(ii) 10% secured loan stock, redemption 31 December 2011 with $5 interest payable per $100 loan stock six monthly on 30 June and 31 December. The current market price is $91.50 ex-interest.

(iii) 8% unsecured convertible loan stock, convertible on 1 January 2009, into 40 ordinary shares. The redemption date is 1 January 2017. Interest is payable annually on 1 January and the current market price is $93 cum-interest.

The sterling debt all has a unit par value of $100. All of Bolar’s marketable debt is redeemable at its par value. Assume that it is now 31 December 2006. Taxation may be ignored.

Required:

(a) Calculate the annual redemption yields for each of the three types of debt. For the convertible loan stock estimate the annual yield if the company’s share price, currently 190 cents, increases by:

(1) 5% per year,

(2) 10% per year.

Assume that, if conversion occurs, the shares would immediately be sold, and that the ex-interest value of convertible loan stock is expected to be $88.50 on 1 January 2009. (15 marks)

(b) Explain briefly why the redemption yields in your answer to (a) above differ. (4 marks)

(c) Assume that the following data concerning government bonds were published in a leading financial newspaper on 1 January 2007.

Yield Interest Redemption Price

Exchequer 13.5% 2007 12.50 5.13 108

Treasury 8.75% 2010 7.87 5.56 111 325

Treasury 11.5% 2014 17 8.77 6.40 131 325

Exchequer 12% 2021 26 8.25 7.00 145 21

Required:

Explain what these data indicate about the term structure of interest rates and briefly discuss possible reasons for this term structure. (6 marks)

(Total: 25 marks)

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HOTALOT CO

Hotalot Co produces domestic electric heaters. The company is considering diversifying into the production of freezers. Data on four listed companies in the freezer industry and for Hotalot are shown below:

Freezeup Glowcold Shiverall Topice Hotalot $000 $000 $000 $000 $000

Non-current assets 14,800 24,600 28,100 12,500 20,600 Working capital 9,600 7,200 11,100 9,600 12,700

_____ _____ _____ _____ _____

24,400 31,800 39,200 22,100 33,300

_____ _____ _____ _____ _____

Financed by: Bank loans 5,300 12,600 18,200 4,000 17,400 Ordinary shares* 4,000 9,000 3,500 5,300 4,000 Reserves 15,100 10,200 17,500 12,800 11,900

_____ _____ _____ _____ _____

24,400 31,800 39,200 22,100 33,300

_____ _____ _____ _____ _____

Revenue 35,200 42,700 46,300 28,400 45,000 Earnings per share (in pence) 25 53.3 38.1 32.3 106 Dividend per share (in pence) 11 20 15 14 40 Price/earnings ratio 12:1 10:1 9:1 14:1 8:1 Beta equity 1.1 1.25 1.30 1.05 0.95 * The par value per ordinary share is 25c for Freezeup and Shiverall, 50c for Topice and $1 for Glowcold and Hotalot. Corporate debt may be assumed to be almost risk free, and is available to Hotalot at 0.5% above the Treasury Bill rate which is currently 9% per year. Corporate taxes are payable at a rate of 30%. The market return is estimated to be 16% per year. Hotalot does not expect its financial gearing to change significantly if the company diversifies into the production of freezers.

Required:

(a) The equity beta of Hotalot is 0.95 and the alpha value is 1.5%. Explain the meaning and significance of these values to the company. (2 marks)

(b) Estimate what discount rate Hotalot should use in the appraisal of its proposed diversification into freezer production. (15 marks)

(c) Corporate debt is often assumed to be risk free. Explain whether this is a realistic assumption and calculate how important this assumption is likely to be to Hotalot’s estimate of a discount rate in (b) above. (8 marks)

(Total: 25 marks)

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GEARBOX CO

Gearbox Co is an all equity company needs to raise finance and has the choice of issuing more equity or issuing long term debt. There is some disagreement on the board about which source of finance would be better. Comments have been as follows:

Board member A

If we issue debt then the gearing of the company will rise. This introduces more risk and to compensate the cost of capital will rise and that will reduce the NPV of projects.

Board member B

Debt is a cheap form of finance, especially as the interest on it will attract tax relief. Even if we did not pay tax, debt is cheaper than equity and the more debt we have then the cheaper our overall mix of finance will be.

Board member C

Both of you are correct in some respects. It’s all a matter of degree: some debt is good, too much is bad, even where there is tax relief.

Required:

Critically appraise the statements made by each board member with reference as necessary to both the traditional and Modigliani and Miller theories of gearing.

(Total: 25 marks)

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SLOHILL INC

Slohill Inc plans to raise finance sometime within the next few months. Slohill's Managing Director remembers the collapse of the market for technology stocks at the end of the 20th Century and the resultant fall in share prices across the board when general share prices fell approximately 30% during one week, and is worried about the possible effects of a further crash on the cost of capital.

Slohill Inc

Summarised Statement of Financial Position as at 31 December 20X7

$ million $ million

Non-current assets (NBV) 262.20

Current assets

Inventory 69.00

Receivables 82.80

Bank 27.60

_____

179.40

_____

Total assets 441.60

_____

Ordinary shares ($l par value) 69.00

Reserves 124.20

_____

Total equity 193.20

11% loan stock 20Z2 138.00

Current liabilities

Payables 75.31

Dividend 8.99

Taxation 26.10

_____

110.40

_____

Total equity and liabilities 441.60

_____

5 year summarised Incomes Statements

Year ended Revenue Profit before Tax Profit after Dividend tax tax $m $m $m $m $m

31 December

20X3 583.7 49.63 19.85 29.78 9.86 20X4 644.6 58.42 20.45 37.97 10.94 20X5 639.5 59.61 20.86 38.75 12.17 20X6 742.3 62.43 21.85 40.58 13.48 20X7 810.6 74.57 26.10 48.47 14.98

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The company's current share price is 546 cents ex div, and loan stock price $93. No new share or loan stock capital has been issued during the last five years. Corporate tax is at the rate of 35%.

If another crash were to occur it would lead to increased demand for gilts and other fixed interest stocks and a decrease of approximately 2% in all interest rates.

Required:

(a) Estimate what effect a second stock market crash of the some magnitude as at the end of the 20th Century might have on Slohill's current weighted average cost of capital if:

(i) The crash has negligible effect on the earnings expectations of the company and on the growth rate of the company's earnings.

(ii) The annual growth rate of the company's earnings is expected to fall by 20% State clearly any assumptions that you make (16 marks)

(b) If a second stock market crash were to occur, advise the Managing Director of the likely effect on the cost of capital of raising a substantial amount of new capital:

(i) if the capital raised is all equity;

(ii) if the capital raised is all debt. (4 marks)

(c) If the capital asset pricing model were to be used to estimate the cost of equity in scenarios (a) (i) and (a) (ii) above explain in which direction the main variables in the model would be likely to move. (5 marks)

(Total: 25 marks)

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GUIDANCE MANUAL

Your company has produced a draft guidance manual to assist in estimating the cost of capital to be used in capital investment appraisal. Extracts from the manual, which includes worked examples, are reproduced below.

Guidance manual for estimating the cost of capital

(i) It is essential that the discount rate used reflects the weighted average cost of capital of the company.

(ii) The cost of equity and cost of debt should always be estimated using market values.

(iii) Inflation must always be included in the discount rate.

(iv) The capital asset pricing model or the dividend valuation model may be used in estimating the cost of equity.

(v) The cost of debt is to be estimated using the redemption yield of existing debt.

(vi) Always round the solution up to the nearest whole percentage. This is a safeguard if the cost of capital is underestimated.

Illustrative examples:

The current date is June 20X7, with four years until the redemption of the loan stock.

Relevant data:

Book values Market values

$m $m

Equity (50 million ordinary shares) 140 214

Debt: 10% bank loans $40m,

10% loan stock 20X3 $40m 80 85

Per share Annual growth rates

Dividends 24 cents 6%

Earnings 67 cents 9%

The beta value of the company (asset beta) is 1.1

Other information:

Market return 14%

Risk free rate 6%

Current inflation 4%

Corporate tax rate 30%

Illustration 1 – When the company is expanding existing activities:

Cost of equity

Dividend valuation model: P

D + g =

428

24 + 0.09 = 0.146 or 14.6%

Capital asset pricing model:

ke = Rf + (Rm − Rf) beta = 6% + (14% − 6%) 1.1 = 14.8%

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Cost of debt

To find the redemption yield, with four years to maturity, the following equation must be solved. Debt is assumed to be redeemed at par value and interest to be payable annually.

Estimates are based upon total interest payments of $80m at 10% or $8m per year.

85 = 8 + 8 + 8 + 88

(1+kd) (1+kd)2 (1+kd)3 (1+kd)4

By trial error

At 9%

8 3.240 = 25.92

80 0.708 = 82.56

56.64

9% discount rate is too high.

At 7% interest

8 3.387 = 27.10

80 0.763 = 88.14

61.04

Interpolating:

7% + (3.14/ (3.14 + 2.44)) 2% = 8.13%

The cost of debt is 8.13%

Market value of equity $214m

Market value of debt $85m

Weighted average cost of capital:

(CAPM has been used in this estimate. The dividend valuation model would result in a similar answer)

(14.8 (214 / 299)) + (8.13% (85 / 299)) = 12.90%

Inflation of 4% must be added to the discount rate.

The discount rate to be used in the investment appraisal is 12.90% + 4% = 16.90% or 17% rounded up to the nearest whole percentage.

Illustration 2 – When the company is diversifying its activities:

The asset beta of a similar sized company in the industry in which your company proposes to diversify is 0.90.

Gearing of the similar company:

Book values Market values

$m $m

Equity 165 230

Debt 65 60

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Cost of equity

The beta of the comparator company is used as a measure of the systematic risk of the new investment. As the gearing of the two companies differs, the beta must be adjusted for the difference in gearing.

Ungearing:

Beta equity = beta asset (E/(E + D (1 − t))

Beta equity = 0.90 (230/(230 60(1 − 3)) = 0.76

Using the capital asset pricing model:

ke = Rf + (Rm − Rf) beta = 6% + (14% − 6%) 0.76 = 12.08%

Cost of debt

This remains at 8.13%

Market value of equity $214m

Market value of debt $85m

Weighted average cost of capital:

(12.08% (214 / (299)) + (8.13% (85/299)) = 10.96%

The discount rate to be used in the investment appraisal when diversifying into the new industry is 10.96% + 4% inflation, 14.96% or 15% rounded up to the nearest whole percentage.

Required:

Produce a revised version of the draft manual for estimating the cost of capital. Revisions, including amended calculations, should be made, where appropriate, to both written guidance note and illustrative examples. Where revisions are made to any of the six guidance notes, or to the illustrations, brief discussion of the reason for revision should be included.

State clearly any assumptions that you make.

10 marks are available for guidance notes and 15 marks for illustrative examples. (25 marks)

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MASTER CO

The directors of Master Co, a large conglomerate which is involved in a wide range of different activities, are considering the possible purchase of Klinard Co, a private company which makes and sells wooden toys, a business which is not currently included among Master Co’s activities. Klinard Co has recently experienced substantial trading difficulties and, if Master Co succeeds in its proposed acquisition, it could replace the existing management of Klinard Co.

The directors of Master Co are unsure as to how the business of Klinard Co should be valued. They are aware that two possible bases exist: either the value of the assets of Klinard Co or its past earnings could be used to determine a purchase price.

Required:

(a) Explain the rationale underlying the assets and the earnings bases of valuation;

(8 marks)

(b) Discuss the practical difficulties which might exist in applying each of the two methods; (10 marks)

(c) Explain how the individual circumstances surrounding the purchase of Klinard Co might determine your choice of method in this case. (7 marks)

(Total: 25 marks)

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FOUNDER

Founder has been advised that were he to allow 25% of the shares in F Ltd to be traded on the Alternative Investment Market, the family company would be able to attract additional investors. The company’s profits arise from Founder’s marketing expertise and financial management.

Each of his two sons currently holds 10% of the equity, his wife owns 25% and Founder himself the remaining 55%.

So that they may take up other investment opportunities in which they have expressed an interest, Mrs Founder and one son will each sell half of their respective interests for cash. Founder himself and the other son are not willing to sell any of the company’s equity that they hold. To meet the needs of the market an additional 300,000 shares will be issued. Both the allotment of the shares to be issued and the sale of existing shares will be scheduled to take place on 31 December 20X1. The proceeds of the new issue will be used to reduce or to discharge borrowings.

The following table summarises F Ltd’s results for 20X1, and a budget for 20X2 before taking account of the proposed share issue:

20X1 20X2

£000 £000

Closing balance sheets:

Operating assets 2,767 3,058

Taxes and dividends payable (344) (381)

Borrowings (290) (118) ____ ____

2,133 2,559 ____ ____

Profit statements:

Operating profit 764 840

Interest paid (38) (33)

Tax provision (254) (282)

Dividends declared (90) (99) ____ ____

Retentions 382 426 ____ ____

Advisers believe that the Alternative Investment Market will trade the company’s shares at a historical price/earnings ratio of 7, if the current dividend policy is maintained.

Required:

(a) Calculate the issue price which is implied by the above information (5 marks)

(b) Prepare a revised budget, assuming that the issue goes ahead as planned, at your calculated price, at a cost of £40,000 (5 marks)

(c) Outline the other factors that a prospective investor would consider when deciding whether to invest in F Ltd (8 marks)

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(d) Outline the changes to F Ltd’s financial control and reporting systems that you would expect to follow from the expanded ownership. (7 marks)

(Total: 25 marks)

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OAKTON PLC

Oakton plc, a company quoted on the London Stock Exchange, has cash balances of £23 million which are currently invested in short-term money market deposits. The cash is intended to be used primarily for strategic acquisitions, and the company has formed an acquisition committee with a remit to identify possible acquisition targets. The committee has suggested the purchase of Mallard plc, a company in a different industry, that is quoted on the AIM (Alternative Investment Market). Although Mallard is quoted, approximately 50% of its shares are still owned by three directors. These directors have stated that they might be prepared to recommend the sale of Mallard, but they consider that its shares are worth £22 million in total.

Summarised financial data

Oakton plc Mallard plc

£000 £000

Turnover 480,000 38,000

Pre-tax operating cash flow 51,000 5,300

Taxation (33%) 16,830

_______

1,749

______

Post tax operating cash flow 34,170 3,551

Dividend 11,000 842

Non-current assets (net) 168,000 8,400

Current assets 135,000 4,700

Current liabilities 99,680

_______

3,900

______

203,320

_______

9,200

______

Financed by:

Ordinary shares (25 pence par) 10,000 (Mallard 10 pence par) 500

Reserves 158,320 5,200

12% Debentures 2006 20,000

10% Bank term loan 15,000

_______

Recent 11% bank loan 3,500

______

203,320

_______

9,200

______

Current share price 785 pence 370 pence

Earnings yield 10.9% 19.2%

Average dividend growth

during the last five years 7% pa 8% pa

Equity beta 0.95 0.8

Industry data:

Average P/E ratio 10:1 6:1

Average P/E of companies recently taken over, based upon

the offer price 12:1 7:1

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The risk free rate of return is 6% per annum and the market return 14% per annum.

The rate of inflation is 2.4% per annum and is expected to remain at approximately this level.

Expected effects of the acquisition would be:

(i) 50 employees of Mallard would immediately be made redundant at an after tax cost of £1.2 million. Pre-tax annual wage savings are expected to be £750,000 (at current prices) for the foreseeable future.

(ii) Some land and buildings of Mallard would be sold for £800,000 (after tax).

(iii) Pre-tax advertising and distribution savings of £150,000 per year (at current prices) would be possible.

(iv) The three existing directors of Mallard would each be paid £100,000 per year for three years for consultancy services. This amount would not increase with inflation.

Required:

Estimate the value of Mallard based upon:

(i) The use of comparative P/E ratios.

(ii) The dividend valuation model.

(iii) The present value of relevant operating cash flows over a 10 year period and critically discuss the advantages and disadvantages of each of the three valuation methods.

Recommend whether or not Oakton should offer £22 million for Mallard's shares.

Approximately 7 marks are available for discussion. (25 marks)

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MEDICONS

MediCons provides a range of services to the medical and healthcare industry. These services include providing locum (temporary) cover for healthcare professionals (mainly doctors and nurses), emergency call-out and consultancy/advisory services to government-funded health organisations. The company also operates a research division that has been successful in recent years in attracting funding from various sources. Some of the employees in this division are considered to be leading experts in their field and are very highly paid.

A consortium of doctors and redundant health-service managers started the company almost 20 years ago. It is still owned by the same people, but has since grown into an organisation employing over 100 full-time staff throughout the country. In addition, the company uses specialist staff employed in state-run organisations on a part-time contract basis. The owners of the company are now interested in either obtaining a stock-market quotation, or selling the company if the price adequately reflects what they believe to be the true worth of the business.

Summary financial statistics for MediCons and a competitor company, which is listed on the country’s Stock Exchange, are shown below. The competitor company is broadly similar to MediCons but uses a higher proportion of part-time staff and has no research capability.

MediCons Competitor

Last year-end: 31.3.20X0

Last year-end: 31.3.20X0

Shares in issue (m) 10 20

Earnings per share (cents) 75 60

Dividend per share (cents) 55 50

Net asset value ($m) 60 75

Debt ratio (outstanding debt as % of total financing) 10 20

Share price (cents) N/A 980

Beta coefficient N/A 1.25

Forecasts:

Growth rate in earnings and dividends (% per annum)

8 7

After-tax cash flow for 20X0/20X1 ($m) 9.2 N/A

Notes

(1) The expected post-tax return on the market for the next twelve months is 12 per cent and the post-tax risk-free rate is 5 per cent.

(2) The treasurer of the company has provided the forecast growth rate for MediCons. The forecast for the competitor is based on published information.

(3) The net assets of MediCons are the net book values of land, buildings, equipment and vehicles plus net working capital.

(4) Sixty per cent of the shares in the competitor company are owned by the directors and their relatives or associates.

(5) MediCons uses a ‘rule-of-thumb’ discount rate of 15 per cent to evaluate its investments.

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(6) Assume that growth rates in earnings and dividends are constant per annum.

(7) The post-tax cost of debt for MediCons and its competitor is 7 per cent.

Required:

Assume that you are an independent consultant retained by MediCons to advise on the valuation of the company and on the relative advantages of a public flotation versus outright sale.

Prepare a report for the directors that provides a range of share prices at which shares in MediCons might be issued. Use whatever information is available and relevant and recommend a course of action.

Explain the methods of valuation that you have used and comment on their suitability for providing an appropriate valuation of the company. In the report you should also comment on the difficulties of valuing companies in a service industry and of incorporating a valuation for intellectual capital. (25 marks)

Note: Approximately one-third of the marks are available for appropriate calculations, and two-thirds for discussion.

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BOND VALUES AND YIELDS

(a) Briefly discuss possible reasons for an upward sloping yield curve. (4 marks)

(b) The financial manager of Gaddes Inc’s pension fund is reviewing strategy regarding the fund. Over 60% of the fund is invested in fixed rate long-term bonds. Interest rates are expected to be quite volatile for the next few years.

Among the pension fund’s current investments are two AAA rated bonds:

(1) Zero coupon June 2022

(2) 12% Gilt June 2022 (interest is payable semi-annually)

The current annual redemption yield (yield to maturity) on both bonds is 6%. The semi-annual yield may be assumed to be 3%. Both bonds have a par value and redemption value of $100.

Today’s date is June 2007

Required:

(i) Estimate the market price of each of the bonds if interest rates (yields):

(1) increase by 1%;

(2) decrease by 1%.

The changes in interest rates may be assumed to be parallel shifts in the yield curve (yield changes by an equal amount at all points of the yield curve). (6 marks)

(ii) Comment upon and briefly explain the size of the expected price movements from the current prices, and how such changes in interest rates might affect the strategy of the financial manager with respect to investing in the two bonds. (3 marks)

(iii) How might the bond investment strategy of the financial manager be affected if the yield curve was expected to steepen (the gap between short- and long-term interest rates to widen), and interest rates are expected to rise? (2 marks)

(c) The funds management team has received data on two other bonds and is considering whether or not to replace an investment in the bonds of Magnacorp with either bonds of Suprafirm or Grandit.

Details of the bonds are presented below:

Magnacorp Suprafirm Grandit

Annual coupon 8.125% 6.5% 7.8%

Maturity date 30/06/2017 30/06/2017 30/06/2011

Credit rating A– BBB+ A–

Market price ($) 107.8 93.1 105.83

Yield to redemption 7.0% 7.5% 6.0%

Redemption price ($) 100 100 100

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Required:

(i) Prepare reasoned advice as to whether or not bonds of Magnacorp should be replaced. (3 marks)

(ii) Evaluate whether or not the market price of Grandit’s bonds in the above table is what would be expected from the company’s other data. (3 marks)

(iii) Discuss whether or not your advice in (a) above would change if the yield curve is upward sloping and the management team expect interest rates to fall, with medium-term interest rates expected to fall by more than long-term interest rates. (4 marks)

(Total: 25 marks)

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FOREIGN EXCHANGE

(a) A company operating in a country having the dollar as its unit of currency has today invoiced sales to the United Kingdom in sterling, payment being due three months from the date of invoice. The invoice amount is £3,000,000 which, at today’s spot rate of 1.5985 is equivalent to $4,795,500.

It is expected that the exchange rate will decline by about 5% over the three-month period and in order to protect the dollar proceeds from the sale, the company proposes taking appropriate action through either the foreign exchange market or the money market.

The $/£ three-months forward exchange rate is quoted as 1.5858-1.5873. The three-months borrowing rate for Eurosterling is 15.0% and the deposit rate quoted by the company’s own bankers is currently 9.5%.

Required:

Explain the alternative courses of action available to the company, with relevant calculations to four decimal places, and to advise which course of action should be adopted. (15 marks)

(b) Required:

Discuss whether a multinational company should hedge translation exposure by incurring transaction exposure. (5 marks)

(c) Required:

Explain briefly what is meant by foreign currency options and give examples of the advantages and disadvantages of exchange traded foreign currency options to the financial manager. (5 marks)

(Total: 25 marks)

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FORUN

(a) Forun plc, a UK registered company, operates in four foreign countries, with total foreign subsidiary turnover of the equivalent of £60 million. The managing director is conducting a strategic review of the company’s operations, with a view to increasing operations in some markets, and to reducing the scale of operations in others. He has assembled economic and other data on the four countries where subsidiaries are located which he considers to be of particular interest. His major concern is foreign exchange risk of overseas operations.

Country UK 1 2 3 4

Inflation rate (%) 4 8 15 9 6

Real GDP growth (%) 1 2 3 2 2

Balance of payments ($b) 12 3 14 5 2 Base rate (%) 6 10 14 10 8 Unemployment rate (%) 12 8 17 4 9 Population (million) 56 48 120 29 9 Currency reserves ($b) 35 20 18 26 3

IMF loans ($b) 4 20 5 5

On the basis of this information the managing director proposes that activity is concentrated in countries 1 and 4, and operations are reduced in countries 2 and 3.

A non-executive director believes that the meeting should not be focusing on such long-term strategic dimensions, as he has just read the report of the finance director who has forecast a foreign exchange loss on net exposed assets on consolidation of £15 million for the current financial year. The non-executive director is concerned with the detrimental impact he expects this loss to have on the company’s share price. He further suggests a number of possible hedging strategies to be undertaken by Forun’s foreign subsidiaries in order to reduce the exposure and the consolidated loss.

These include:

(i) early collection of foreign currency receivables;

(ii) early repayment of foreign currency loans;

(iii) reducing inventory levels in foreign countries.

Required:

(i) Discuss whether or not you agree with the managing director’s proposed strategy with respect to countries 1 to 4. (7 marks)

(ii) Give reasoned advice as to the benefit to Forun plc of the non-executive director’s suggested hedging strategies. (8 marks)

(b) Forun has a number of intra-group transactions with its four foreign subsidiaries in six months time, and several large international trade deals with third parties. These are summarised below. Intra-group transactions are denominated in US dollars. All third party international trade is denominated in the currency shown. It is now 1 June.

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Intra-group transactions

Paying company Receiving UK Sub 1 Sub 2 Sub 3 Sub 4 company

$US000

UK 300 450 210 270

1 700 420 180

2 140 340 410 700

3 300 140 230 350

4 560 300 110 510

Exports to third parties

Receipts due in six months:

£2,000,000 from Australia

A$3,000,000 from Australia

$12 million from the USA

Imports from third parties

Payments due in six months:

£3,000,000 to the USA

A$3,000,000 to Australia

£2,000,000 to France

Foreign exchange rates Spot 3 mths forward 6 mths forward

US$/£ 1.4960 1.4990 1.4720 1.4770 1.4550 1.4600

Australian$/£ 2.1460 2.1500 2.1780 2.1840 2.2020 2.2090

Required:

(i) Explain and demonstrate how multilateral netting might be of benefit to Forun plc. (5 marks)

(ii) Show how the company might use the forward market to protect itself against short-term foreign exchange exposure. (5 marks)

(Total: 25 marks)

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EXCHANGE RATES

(a) Your managing director has received forecasts of Euro exchange rates in two years’ time from three leading banks.

Euro/£ two year forecasts

Alpha bank 1.162

Bravo bank 1.211

Charlie bank 1.426

The current spot mid-rate is Euro 1.334/£.

A non-executive director of your company has suggested that in order to forecast future exchange rates, the interest rate differential between countries should be used. She states that ‘as short term interest rates are currently 5% in the UK, and 2.5% in the Euro bloc, the exchange rate in two years’ time will be Euro 1.4/£’.

Required:

(i) Discuss the likely validity of the non-executive director’s estimate. (4 marks)

(ii) Explain briefly whether or not forecasts of future exchange rates using current interest rate differentials are likely to be accurate. (5 marks)

(b) You have also been asked to give advice to the managing director about a tender by the company’s French subsidiary for an order in Kuwait. The tender conditions state that payment will be made in Kuwaiti Dinars 1 year from now. The subsidiary is unsure as to what price to tender. The marginal cost of producing the goods at that time is estimated to be Euro 290,000 and a 30% margin is normal for the company.

Exchange rates

Euro/Dinar

Spot 0.273

No forward rate exists between the Euro and the Dinar.

Euro Kuwait

Annual inflation rates 3% 7%

Required:

(i) Calculate the expected spot rate between the Euro and the Dinar in one year’s time using purchasing power parity theory. (2 marks)

(ii) Calculate the tender price in Euros. (1 mark)

(iii) Calculate the tender price in Dinars using the forecast of the spot rate in one year’s time. If this price is set discuss whether or not the company is hedged against foreign exchange rate risk. (3 marks)

(iv) Explain why an option to sell Dinars in one year’s time might be an attractive hedging technique in this situation. (3 marks)

(c) Contrast and compare the objectives of a company with those of a not for profit organisation. (7 marks)

(Total: 25 marks)

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EXCHANGE RISK AND CASH BUDGETS

(a) Discuss briefly five techniques a company might use with respect to the foreign exchange risk involved in foreign trade. (10 marks)

The exchange rate between two currencies is shown as A$/C$ 3.451 ± 0.003 and the three month forward rate is 3.487 ± 0.005.

Required:

(b) Calculate the C$ receipt of exchanging A$ 200,000 now or in three months time. Identify which currency is appreciating and which is depreciating. (3 marks)

A company has forecast sales in month 1 of 20,000 units. This level of sales is expected to grow by 1,000 units each month over the next year. Production is arranged such that at the end of any month 50% of the units to be sold in the next month are in inventory. Each unit requires 2kg of a raw material which costs $3.50 per kg. Inventory of raw material at each month end is always sufficient to satisfy 30% of the next month's usage. The supplier of raw material is paid one month in arrears but gives a discount of 2% if monthly purchases exceed 45,000 kg.

Required:

(c) Calculate the payment made to the supplier in month 4. (6 marks)

(d) State and explain 3 of the motives a company may have for holding cash. (6 marks)

(Total: 25 marks)

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